The Case for 1-Month Options

I sell predominantly one-month options. This decision was NOT based on anything I read or was told, but rather on experience and common sense. Most stocks with options have at least four expiration cyclesaffiliated with them at any point in time…the current month, the next month and two more months further out based on the particular option cycle that particular equity has been assigned to. Stocks that also have LEAPS (long-term options) have more than four cycles. Using the options chains and the Ellman Calculator, I will make my case for selling mainly one-month options.

Three Reasons to Sell One-Month Options

1- It facilitates adhering to a core BCI guideline of never selling an option in a contract cycle that has an upcoming earnings report. Since earnings reports are made public on a quarterly basis for U.S. companies, selling short-term options allow us to move our stocks in and out of our portfolios (yet keep them on our watch lists if they still meet our system criteria).

2- Stocks have no loyalty to us. They can be our best friends one month and our worst enemies the next. Although we do have exit strategies to help control a negative situation (detailed in all my books and DVDs), the shorter the commitment we have to an equity, the less risk we incur.

3- We make the most money selling one-month options. I’m sure I have your attention now, so allow me to demonstrate via an options chain for Netlogic Microsystems (NETL), currently trading for $53.22 as shown in the figure below:

NETL- current price

The option chain is shown in the chart below:

NETL- options chain

This information was captured after the February contracts expired. We will hone in on the March (one month out), April (two-months out) and July (five months out) contracts. Here is the information we glean from the options chain and will feed into the Ellman Calculator (single tab):

The stock is trading @ $53.22 so we will look at the $55 call options

The March $55 call returns $1.65/share (red circle)

The April $55 call returns $2.55/share (blue circle)

The July $55 call returns $4.70/share (green circle)

It may be tempting to opt for the higher dollar returns of the longer-term options; however we must factor in the time frame and logically deduce how to best put our money to work so as to generate the most profits. So let’s feed this information into the single tab of the Ellman Calculator, as illustrated in the chart below:

The Ellman Calculator- single tab

Now, in the next chart let’s examine the results of these calculations:

Calculations

The ROO or initial percentage returns generated does NOT include the upside potential. Although the Ellman Calculator does give this information, I left it out of this graphic because all choices have the same upside, and I want to concentrate just on the initial option profit. Here are the ROO figures derived from the Ellman Calculator:

The March $55 call returns 3.1% (green arrow)

The April $55 call generates 4.8% (blue arrow)

The July $55 call generates 8.8% (red arrow)

Once again, upon first glance it appears that the July $55 call will be the most lucrative for us until we annualize these percentages. To do so, we must convert these figures to a monthly return and multiply by 12, as follows:

March: 3.1%/1 x 12 = 37.2%

April: 4.8%/2 x 12 = 28.8%

July: 8.8%/5 x 12 = 21.1%

The one-month options outperformed the two-month options by more than 29% and the five-month options by more than 76%! I rest my case.

Video highlighted on homepage– Multiple Exit Strategies for the Same Contract Period:

Are you as angry as I am about the way Congress is representing our interests? This past week, the Super Committee’s failure to come up with $1.2 trillion in budget savings over the next ten years was yet another breakdown by Congress impacting our well-being (it should not, however, affect the U.S. credit rating or the interest rates paid on Treasuries or their value). Like spoiled little children our representatives are putting their mean-spirited politics above the best interests of the folks. In our BCI methodology of screening for stocks, the number one screen is “are options available”. This is an essential requirement for covered call writing. It is so obvious that some of you have suggested removing it from the stock screen. Can we draw an analogy as to the first screen or requirement for selecting a Senator or Representative? How about having the ability to compromise and negotiate? Too obvious and simple to mention? Not any more in my view. Most members of Congress don’t pass the first screen! Our watch list of politicians can be counted on one hand. Why can’t they understand that they represent all the people not only those that agree with their every talking point? Derek Jeter thinks he’s worth $20 Million/year for 4 years. The Yankees think he’s worth $15 Million/year for 2 years. He gets $15 Million/year for 3 years and everybody is happy. Both sides were represented. This viewpoint may be a bit overstated as there are probably a decent percentage of fair, competent and hard-working members of Congress. The others need to go and quickly. This isn’t American Idol where we may vote for our favorite character. In the eyes of this investor, if you are a member of Congress and you can’t compromise and negotiate or simply won’t you must go… now. Then let them try to get a job and see what it feels like on the other side. Enough venting!

This holiday-shortened week’s economic reports were positive but muted due to the failure of the supercommittee, Europe’s debt crisis and the Fed’s announcement of future stress tests for 31 US banks:

GDP was revised downward to 2% annualized (from 2.5%) however…

3rd quarter GDP was an upgrade from the 0.4% in the 1st quarter and the 1.3% in the 2nd quarter

The revision was due to a decline in inventories which bodes well for 4th quarter production

Corporate profits rose by 2.1% in the quarter much better than the 1% in the 1st quarter but less than the 3.3% in the 2nd quarter

For the week, the S&P 500 declined by 4.7% for a year-to-date return of (-) 6.2% including dividends.

Technically, the market tone is in negative territory. The VIX currently sits @ 34.47, well above our comfort level of under 30. The 6-month chart of the S&P 500 shows that the benchmark has dropped below its recent trading range support (green arrow):

S&P 500 as of 11-25-11

On a positive note corporate earnings continue to impress and December is the month that pensions are funded with stocks.

Summary:

IBD: Market in correction

BCI: The BCI is taking a neutral but cautious stance on the market selling only in-the-money strikes and favoring low-beta stocks and ETFs.

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies. Google +

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I’m having a problem with the weekly reprot – the margins are too small to print direct without trimming the test at the left. I downloaded the file and ran Adobe Reader and told it to fit to print area and it printed ok, but I can’t print directly from Chrome any longer.

If you can easily fix this great. If not I wanted to pass the fix along.

The size of the report can be controlled at the top of the page (red arrow below). When printing use “fit to printable area” as shown in the screenshot below. Click on image to enlarge and use the back arrow to return to this blog.

With so few candidates passing our strict BCI screens due to the recent market decline we have an unusual dilemma for those entering new positions. One approach to consider would be to use one or more of the stocks with mixed technicals along with ETFs (from the report our team generated on Thursday). Additional protection can be generated by selling in-the-money strikes until the market begins to recover.

Alan
As usual, your article is both informative and provocative. Based upon all of the reasons why you favor one month options over longer term ones, shouldn’t one week options make even more sense (at least with respect to the somewhat limited number of stocks for which they are available)?
Thank you for all that you do for your followers.

Allow me to qualify this statement before I type. This is my first month to be a premium member. I read Alan’s book about a year ago and have been trading CC’s ever since. My record in that 12 months is about -1% APR. I pray (for my little girl’s college fund) that using this service will help my APR increase for 2012.

Having said that, EBIX looks to be on a nice run. I put in a pretrade order to buy stock @ $19.03 sell $19 STRIKE @ $0.90. 4.46% return if called out.

Market conditions and products have changed since 2007 when my first book was published. Our markets are now impacted by the global economy as well as other factors like flash trading, the expansion of derivatives and ETFs which have made the norm more volatile than in the past.

#15, Frank, I too have invested in EBIX from the recent list. I have 10 contracts @30cents with a ROO of 1.5%. If called away however I would have a upside potential of 5.1% and a total return of 6.6%. (annualized @ 133.8%).
Bought at 19.98 and have a strike at 21.00.

Yesterday’s huge bullish move in the market was much more than positive central bank actions. There also has been a load of positive economic indicators. These included a rise in new home sales, a positive ADP jobs report and most of all (as I have been reporting for months) record corporate profits. December is traditionally a positive month for the market so a rally through the end of the year would not surprise me. I still remain cautious (hello Europe) but fully invested.

Today many of our “banned stocks” reported monthly sales stats and most did well. One great example of why we avoid these stocks in the BCI methodology is exemplified by what happed to Kohls (KSS). It posted a surprise drop in November same-store-sales and lost 7% of its share price at the time of this post. These monthly reports represent the same risk as quarterly earnings reports and in my view should be avoided. Premium members can find the complete list in the “resources/downloads” section of the premium site. It is also found in my first and third books. I’d also be happy to email you a copy:

Adding to Alan’s comment, the bulk of the big up move in the S&P, DOW, and NASDAQ yesterday (11/30/11) was in overnight markets. There was a big gap up at the open (approx. 392 points on the DOW) and most retail traders were not able to trade it…the move was in Asia and Europe overnight.

Could the BCI team do me a favor please? I’m just getting interesting in using the ETF report, but it is color coded. I am a bit color blind and can’t tell green from brown from red very well. (This problem afflicts about 10% of all men), Could you use dotted lines or put small notes at each line. It would help enormously.

On page 264 on your latest book you discuss closing your position if the “time value approaches zero”. Then using the cash to establish a second position in the same month. What would you do if that happened let’s say with only one week or a few days left in the contract? Thanks for all your help.

Thanks very much for pointing out this issue. Let me know if this information will suffice:

ALL charts are color-coded in the same manner:

Blue = best performer on chart

Green= next best

Brown = 3rd best

Purple = 4th best (Inverse ETF only)

Black = benchmark or S&P 500

All charts are color-coded in this same manner. See the chart below as further explanation. Let me know if having this information will suffice. If not, my team and I will try to figure out something else. Click on the image to enlarge and use the back arrow to return to this blog.

You missed the point – color blind means I can’t tell these colors apart – it is fairly common and makes the charts almost useless. If you use the arrows shown above or better yet different dotted and solid lines (with a list of how they are coded) that would work. Try printing out the diagrams in black and white and try to interpret them – that will explain the problem.

I’m trying not to clutter the chart but will do what it takes to make this usable for our members with this issue. Let me add to my previous remarks:

Since the order is ALWAYS Blue-Green-Brown
best to worst, Blue will always be on top, green next and so on. Also, I provide percentiles so ITB in the screenshot is @ + 17%. Blue may be difficult to discern but since ITB is + 17%, it can easily be identified. Does this additional info help?

It’s hard to follow when they cross over each other – can you use dotted line for one, solid of another, solid with circle, solid with diamond – I believe this is all available in Excell. Any non-color differentiation that doesn’t clutter would be helpful.

I just did a sample chart in Open Office and when I included points it did what I need automatically. Can you chart program do this? I also sent an email with this so I could just paste in a chart – too much hassle to make a file and attach

Whenever you can close a position with maximum profit (initial option return + share appreciation to the strike) at low or no cost (premium trading at parity or all or nearly all intrinsic value) the position should be closed. Now the question arises as to whether to use that cash to establish another cc position with that same cash in the same contract month. If you can generate 1-2% or more with a low risk investment, I say why not? If you can’t you can move to the next month or wait until the current month expires (my preference). In the example you alluded to in my new book, I generated an additional 2.2% initial premium profit which had a downside protection of 3.7% (chart on page 271).

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To send us an email, contact us here. Subscribe to our e-mail newsletter or RSS feed to receive updates. Contact us by phone at 866-892-2187. Additionally you can also find us on any of the social networks below: